Midland Energy Resources Inc. Cost of Capital. Dr. C. Bulent Aybar

Transcription

1 Midland Energy Resources Inc. Cost of Capital Dr. C. Bulent Aybar

2 Midland Energy: Highlights Midland is a global energy company with operations in oil and gas exploration and production (E&P), refining and marketing (R&M), and petrochemicals. On a consolidated basis, the firm had 2006 operating revenue and operating income of $248.5 billion and $42.2 billion, respectively. Largest fraction of assets are tied in Exploration and Production, but largest share of revenues are produced by Refining and Marketing.

3 Division Revenues

4 Division Assets

5 Operating Revenues and Income Operating Results: Operating Revenues $201,425 $249,246 $248,518 Plus: Other Income 1,239 2,817 3,524 Total Revenue & Other Income 202, , ,042 Less: Crude Oil & Product Purchases 94, , ,131 Less: Production & Manufacturing 15,793 18,237 20,079 Less: Selling, General & Administrative 9,417 9,793 9,706 Less: Depreciation & Depletion 6,642 6,972 7,763 Less: Exploration Expense Less: Sales-Based Taxes 18,539 20,905 20,659 Less: Other Taxes & Duties 27,849 28,257 26,658 Operating Income 29,005 41,294 42,243 Less: Interest Expense 10,568 8,028 11,081 Less: Other Non-Operating Expenses Income Before Taxes 17,910 32,723 30,447 Less: Taxes 7,414 12,830 11,747 Net Income $10,496 $19,893 $18,701

6 Assets and Liabilities Assets: Cash & Cash equivalents $16,707 $19,206 Restricted Cash 3,131 3,131 Notes Receivable 18,689 19,681 Inventory 6,338 7,286 Prepaid Expenses 2,218 2,226 Total Current Assets 47,083 51,528 Investments & Advances 30,140 34,205 Net Property, Plant & Equipment 156, ,350 Other Assets 10,818 9,294 Total Assets 244, ,378 Liabilities & Owners' Equity: Column1 Column2 Accounts Payable & Accrued Liabilities 24,562 26,576 Current Portion of Long-Term Debt 26,534 20,767 Taxes Payable 5,723 5,462 Total Current Liabilities 56,819 52,805 Long-Term Debt 82,414 81,078 Post Retirement Benefit Obligations 6,950 9,473 Accrued Liabilities 4,375 4,839 Deferred Taxes 14,197 14,179 Other Long-Term Liabilities 2,423 2,725 Total Shareholders' Equity 77,493 97,280 Total Liabilities & Owners' Equity $244,671 $262,378

7 Objective: Calculation of WACC for Midland and Its Divisions Why Mortensen is calculating WACC for the corporate and divisions? WACC is used in Routine capital budgeting metrics such as NPV, asset appraisals for financial accounting exercises such as FAS 142 impairment testing, Analyses of stock repurchases Assessment of M&A proposals.

8 WACC In respective applications the WACC is intended to represent the long-term opportunity cost of funds for Midland, one of its divisions, or an acquisition target; It is the discount rate, or a benchmark for the discount rate in a discounted cash flow (DCF) analysis. In addition, Mortensen s numbers likely will be used in performance assessments at the corporate and division levels and may well affect incentive compensation awards.

9 Capital Structure It is generally helpful to rearrange a GAAP balance sheet before computing capital structure ratios to separate operating from financial accounts and to define capital as it will appear in the denominator of the capital structure ratios. For example, trade-related liabilities, such as payables and accruals, should be grouped on the left side and netted against current assets; they generally should be thought of as part of net working capital, not funded debt. Likewise for long-term accruals which may be netted against other longterm assets. In contrast, some assets notably cash and marketable securities may represent excess liquidity and should be netted against debt before the ratios are computed.

10 Rearranged Balance Sheet NWC Notes Receivable 19,681 Net Debt Financial Account Inventory 7,286 Current Portion of Long-Term Debt 20,767 Prepaid Expenses 2,226 Long-Term Debt 81,078 Less Less: Cash and Equivalents $19,206 Accounts Payable & Accrued Liabilities -26,576 Restricted Cash 3,131 Deferred Taxes -5,462 Net Debt $79,508 Net Working Capital -2,845 Shareholder's Equity 97,280 Net Fixed Assets Net Capital 176,788 Investments & Advances 34,205 Net Property, Plant & Equipment 167,350 Other Assets 9,294 Less Post Retirement Benefit Obligations 9,473 Accrued Liabilities 4,839 Deferred Taxes 14,179 Other Long-Term Liabilities 2,725 Net Fixed Assets 179,633 Net Operating Assets 176,788 Note that market value of the equity is given as $134.1bn in Exhibit-5. This assumes a year end share price of $45.45 and million outstanding shares. This suggest a D/E ratio of 59.3% which corresponds to 37.2% Debt/Value ratio and 62.8% Equity/Value ratio.

11 Capital Structure and Component Weights In component weight calculations it is important to use market value of debt and equity. In this particular case we have the data on outstanding shares and the stock price for each quarter. We could use fourth quarter price listed in Exhibit-4 along with the number of outstanding shares to determine the market value of equity: $44.11 x 2,951=$130,160 However this does not match the market value of equity ($134,114) listed in Exhibit-5. Apparently stock price as of 12/31/2006 is $45.45 and this is different than the fourth quarter average of $ In the calculation of 59.3% of D/E ratio, book value of debt (79,508) was used (79,508/134,114=0.593)

12 Comparables (in $ millions) Exploration & Production: Market Value Debt D/E Equity Beta LTM Revenue LTM Earnings Jackson Energy, Inc. $57,931 $6, % 0.89 $18,512 $4,981 Wide Plain Petroleum 46,089 39, % ,827 8,495 Corsicana Energy Corp. 42,263 6, % ,505 4,467 Worthington Petroleum 27,591 13, % ,820 3,506 Average 39.83% 1.15 Refining & Marketing: Bexar Energy, Inc. 60,356 6, % ,708 9,560 Kirk Corp. 15,567 3, % ,751 1,713 White Point Energy 9,204 1, % ,682 1,402 Petrarch Fuel Services 2,460 (296) , Arkana Petroleum Corp. 18,363 5, % ,117 3,353 Beaumont Energy, Inc. 32,662 6, % ,989 1,467 Dameron Fuel Services 48,796 24, % ,750 4,646 Average 20.30% 1.20 Midland Energy Resources $134,114 $79, % 1.25 $251,003 $18,888

13 Capital Structure Should we use the current capital structure, or should we consider target capital structure in WACC calculation?

14 Cost of Equity: Risk Free Rate The risk-free return for U.S. dollar cash flows is conventionally derived from returns on U.S. Treasury obligations. Ideally, the maturity of the benchmark T-bond should match the term of the subject cash flows. In theory, this implies different risk-free rate for each cash flow whenever the yield curve is not flat. More precisely, it suggests we use the forward rate derived from the zero-coupon Treasury yield curve for each discounting period in the DCF calculations. A far more common practice is to simply take the yield on a long-term Treasury bond as the risk-free rate.

15 What Maturity for Risk Free Rate? The case gives the yield on the 1, 10 and 30-year T-bonds. Should the choice of maturity depend on the projection period? Remember that a DCF analysis of a going concern actually incorporates a terminal value intended to reflect the value derived from cash flows well beyond the discrete projection period. In other words, many projects in companies such as Midland are indeed long-term projects, despite the fact that cash flows are not explicitly forecasted beyond a few years. Accordingly, the risk-free rate still should be derived from a long-term instrument.

16 Treasury Yields and Division Cost of Debt Maturity Rate: 1-Year 4.54% 10-Year 4.66% 30-Year 4.98% Spread over Business Segment: Credit Rating Debt/Value Treasury Consolidated A % 1.62% Exploration & Production A % 1.60% Refining & Marketing BBB 31.00% 1.80% Petrochemicals AA % 1.35%

17 Cost of Debt for E&P Division Credit Debt/ Spread to Rating Value Treasury Business Segment: Consolidated A+ 42.2% 1.62% Exploration & Production A+ 46.0% 1.60% Refining & Marketing BBB 31.0% 1.80% Petrochemicals AA- 40.0% 1.35% Note: Debt/Value is based on market values. Since the 10 year Treasury note yield is given as 4.66%, the cost of debt for E&P division is: R d = R f +CRS R d = 4.66%+1.60% = or 6.26%

18 Cost of Equity: EMRP A fairly concise recent review of research and practice on the EMRP is presented by Pratt and Grabowski (2008), who review a wide variety of methods and data to support a range for the EMRP of 3.5% to 6.0%. Their point estimate for 2007 is 5.0%. This is consistent with the premia used by auditors, appraisers, investment bankers, consultants, and other valuation specialists in realworld settings. Academics tend to favor somewhat higher rates. Many practitioners derive estimates of the EMRP from data published in Ibbotson Associates Annual Cost of Capital Yearbook. These data are generally highly regarded, and used by the practitioners.

19 EMRP Researcher Survey Subjects Dates Respondents Risk Premia 500+ finance & Median: 3.6% Welch economics Professors 2001 Interquartile range: 2.6%-5.6% Graham & Harvey ~400 U. S. CFOs Quarterly Range: 2.5% - 4.7% Most recent survey (4Q2006): 3.3% Greenwich Associates US Pension Fund Managers 2006 Range-2%-4%

20 Cost of Equity: Beta Equity betas vary with leverage and Midland s reported beta of 1.25 reflects its current capital structure, which differs from its (stated) target capital structure. If the estimated WACC is to properly reflect the target capital structure, the cost of equity must reflect it as well. To adjust Midland s beta to reflect the higher leverage embedded in the target capital structure we need to un-lever the current beta to remove the effect of the current capital structure, then re-lever it to reflect the target.

21 Estimating Project Beta using Comparables Financial analysts use pure-play method to estimate beta for a company or project that is not publicly traded. Pure - play method requires using a comparable publicly traded company s beta and adjusting it for financial leverage differences. This requires a process of unlevering and levering the beta. The beta of the comparable is first unlevered by removing the effects of its financial leverage. The unlevered beta is referred to as the asset beta because it reflects the business risk of the assets. Once we determine the unlevered beta, we adjust it for the capital structure of the company or project that is the focus of analysis.

22 Relationship between Asset Beta and Equity Beta Because a levered company s risk is shared between creditors and owners, we can represent the company s risk, b asset, as the weighted average of the company s creditors market risk, b debt,and the market risk of the owners, b equity : D E b b b D E D E asset debt equity Since interest on debt is deducted by the company to arrive at taxable income, the claim that creditors have on the company s assets does not cost the company the full amount but rather the after - tax claim; the burden of debt financing is actually less due to interest deductibility.

23 Asset Beta and Equity Beta If we account for tax deductibility of interest, we can express asset beta as follows: (1 t) D E b b b (1 t) D E (1 t) D E asset debt equity We generally assume that a company s debt does not have market risk; so b debt = 0. With this assumption asset beta reduces to the following: b asset 1 1 (1 t)( D / E) b equity

24 Unlevered Beta From Exhibit 5, we know that Midland s current D/E ratio is The target Debt/Value ratio given in Table-1 is 42.2%. This implies 57.8% Equity/Value or a D/E ratio of If we unlever Midland s beta by using its current capital structure and tax rate : β unlevered = β levered /[1+(1-t)D/E]. Therefore β unlevered = 1.25/[1+( )(0.593)] = 0.92

25 Re-levered Beta If we use the target capital structure ratio to re-lever the unlevered beta of 0.92: β levered = [1+(1-t)D/E] x β unlevered = [1+ ( )(.73)] x 0.92 = 1.33 This levered beta is then used above to obtain a cost of equity of: k e = 4.66% (5.00%)=11.31% k e = 4.66% (5.00%)=10.91% Increasing the leverage towards the target capital structure increases the cost of equity by (11.31%-10.91%)=0.4% or 40bp

26 Cost of Debt Ideally, the cost of debt in a calculation of WACC should be the expected return on a traded, longterm fixed-rate obligation of a credit quality that corresponds to the capital structure ratios built into the WACC formula. Credit Spread Cost of Debt Exploration & Production: 1.60% 6.26% Refining & Marketing: 1.80% 6.46% Petrochemicals 1.35% 6.01%

27 Divisional WACC The first step in divisional WACC calculations is the divisional beta calculations. In the case, we are given data about comparable companies in Exploration and Production as well as Refining and Marketing. We can use this data to calculate asset betas in each business segment. We can use average asset betas in segment and substitute these average asset betas for divisional asset betas. Consequently, we can re-lever asset betas to calculate divisional equity betas by using respective capital structure of each division.

28 Divisional Beta Calculations-Step-1 Exploration & Production: Market Value Debt D/E Equity Beta Asset Beta Jackson Energy, Inc. $57,931 $6, % Wide Plain Petroleum 46,089 39, % Corsicana Energy Corp. 42,263 6, % Worthington Petroleum 27,591 13, % Average 39.83% Refining & Marketing: Bexar Energy, Inc. 60,356 6, % Kirk Corp. 15,567 3, % White Point Energy 9,204 1, % Petrarch Fuel Services 2,460 (296) Arkana Petroleum Corp. 18,363 5, % Beaumont Energy, Inc. 32,662 6, % Dameron Fuel Services 48,796 24, % Average 20.26% Midland Energy Resources $134,114 $79, %

29 Divisional Beta Calculation Step-2: Weighting by Earnings D/E Equity Beta Asset Beta Earnings % Consolidated 59.30% % Exploration & Production: 85.19% % Refining & Marketing: 44.93% % Petrochemicals 66.67% % While we are given data on two segments, we do not have information on petrochemicals. We can infer asset beta from what we already know. Since Midland s corporate asset beta should be equal to weighted average of its divisional asset betas, we can extract the third division beta from the information that we have. One practical question/issue in this approach is the determination of weights. How should attribute divisional weights? Based on asset size? Net income? Operating Income?

30 Weighting by Assets Equity Asset LTM Net % Midland Energy Resources: D/E Beta Beta Revenue Income Assets Consolidated 59.3% ,518 18, % Exploration & Production 85.2% ,357 12, % 0.93 Refining & Marketing 44.9% ,971 4, % 1.05 Petrochemicals 66.7% ,189 2, % 0.46

31 Divisional WACC Target Target Asset Equity Cost of Cost of Midland Energy Resources: D/E D/V Beta Beta Equity Debt WACC Target Consolidated 73.0% 42.2% % 6.30% 8.13% Exploration & Production 85.2% 46.0% % 6.26% 8.05% Refining & Marketing 44.9% 31.0% % 6.46% 9.01% Petrochemicals 66.7% 40.0% % 6.01% 6.16% Prevailing Consolidated 37.2% % 6.62% 8.33%

32 WACC for Midland and Its Divisions Division Target D/E D/V Equity Beta Asset Beta Cost of Equity Cost of Debt WACC Consolidated 73.00% 42.20% % 6.28% 8.13% Exploration & Production: 85.19% 46.00% % 6.26% 8.04% Refining & Marketing: 44.93% 31.00% % 6.46% 9.02% Petrochemicals 66.67% 40.00% % 6.01% 6.80% Assumptions Debt Beta 0 10-Year Treasury Bond 4.66% EMRP 5.00% Tax Rate 40.00% Division Credit Spread Cost of Debt Exploration & Production: 1.60% 6.26% Refining & Marketing: 1.80% 6.46% Petrochemicals 1.35% 6.01%

33 Corporate WACC vs Divisional WACC Using a single WACC in all divisions may have two problematic implications: 1) Company invests in projects that appear positive NPV, but this happens because discount rate is set too low, in reality these projects have negative NPV (Type-1 errors) 2) Company rejects good projects, because WACC is set too high (Type-2 errors) In both cases, firm underperforms.